Type of Lawsuit: Applicant sued the issuer, the negotiating bank, and the beneficiary to enjoin payment on four LCs.

Parties: Plaintiff/Appellee/Applicant- European & Asia Economic and Trade Corporation, Sichuan Province (PRC) Defendant/Appellant/Beneficiary- Xinhu Shangshe (Republic of Korea) Third Party/Issuer- Chengdu Zongfu Branch of the Agricultural Bank of China * Jin Saibo is a Partner at Beijing Yiwen Law Firm, PRC. Zhou Feng is an Associate at Beijing Yiwen Law Firm, PRC.. 28 Third Party/Negotiating Bank- Central Committee of South Korea Agricultural Association

Underlying Transaction: Sale of goods.

LC: Four LCs for US$9,867,591.83.

Decision: The PRC Supreme People's Court dismissed an appeal by the beneficiary from an order of the Sichuan Provincial High People's Court rejecting the beneficiary's objection to jurisdiction.

Rationale: Court has jurisdiction over the underlying contract since the arbitration clause in it is ambiguous and unenforceable. Court also has jurisdiction over the LC issued pursuant to the underlying contract due to material fraud found in underlying contract.

Factual Summary: Four LCs were issued for payment of four sales contracts. The Korean beneficiary presented fabricated documents to the negotiating bank, which later forwarded the documents to the issuer. According to the Court Order, the appellant court found that although the negotiating bank knew the documents were fabricated, it forwarded the documents and successfully obtained the issuer's acceptance of draft(s) under the LCs. Meanwhile, the applicant discovered that the vessel and the goods as described in the B/L had never arrived at the destination port. After the presentation and issuer's acceptance but before payment, the applicant sought and obtained from the Sichuan High People's Court an order to stop payment under the four LCs and later filed a lawsuit before the same court against the beneficiary with the issuer and the negotiating bank listed as third parties. The beneficiary objected that the court lacked jurisdiction, referring to the arbitration clause in each of the sales contracts, which stated that "all the disputes rising between the parties should be finally submitted to a commercial arbitration committee of a third country for settlement according to the commercial arbitration rules". The Sichuan Court (trial court) rejected the beneficiary's objection. On appeal the Supreme Court affirmed.

Legal Analysis:

1.Arbitration Clause: The beneficiary/seller contended that the court did not have jurisdiction of a dispute with the applicant/buyer regarding a drawing on the LCs because of an arbitration clause in the underlying sales contract. The trial court held that the action for injunction related to the LC and not to the underlying contract. The appellate court, however, stated that "It is improper for the first instance court to hold that what it was hearing was only the LC relationship, and by doing so it was thus not addressing the suit of the applicant." While recognizing that Chinese law makes agreements to arbitrate enforceable, the Court declined to enforce this clause due to its ambiguity, namely that since it "did not establish the means of arbitration or the arbitral body, it is proper for the first instance court to accept the suit."

2. Fraud in the Underlying Transaction: The applicant sought a stop payment order against the beneficiary on the basis of fraud in the transaction. The appellate court noted that "although an LC is a mode of payment for the underlying transaction, it is a documentary transaction independent from the underlying transaction and following the strict compliance principle." While indicating that a "default in the underlying transaction" is not normally a basis for relief from the LC obligation, the court indicated that "fraud is an exception to the above principle. The so-called 'fraud exception' can only be established as an exception to the independence principle when 2001 LC CASE SUMMARIES there is material fraud with respect to the underlying transaction, The precondition for applying the 'fraud exception' is the existence of fraud in the underlying transaction that will cause the court to stop payment under the LC; therefore, the court must consider both the underlying transaction and the LC relationship."

3. Injunction, Effect on Issuer and Nominated Bank: The trial court had included the issuing bank and the negotiating bank as third parties in the action. The appellate court approved, indicating that there was available a procedure whereby they could be made parties to the action and indicated that such a step would be appropriate since the outcome "will necessarily affect the performance of the issuer, who either does or does not have the responsibility to pay the negotiating bank."

Comment by Jin Saibo:

1.Jurisdiction: There is no doubt in this case that under PRC law the court has jurisdiction over an underlying contract when the arbitration clause is ambiguous or unenforceable and the parties to the contract fail to reach an arbitration agreement. The question is whether the court also has jurisdiction over the LC, which is issued pursuant to the underlying contract where the cause of action is fraud with respect to the underlying contract. According to the independence principle, a court with jurisdiction over the underlying contract generally does not automatically have jurisdiction over the LC. Accordingly, a party to the underlying contract cannot obtain an order from a court simply because it has jurisdiction over the underlying contract to stop payment under the LC and have the LC declared void by pointing to ordinary defaults occurred in the performance of the underlying contract.

2. Fraud Exception and Material Fraud: The order in this case clearly shows the PRC Supreme Court's position on this issue. The Supreme Court expressly adopts the "fraud exception" in this case and takes the fraud exception to be a precondition for considering both the underlying contract and LC transaction simultaneously in an underlying contract dispute. It also provides for the first time a standard to recognize the type of fraud sufficient to qualify for the "fraud exception" in LC cases. Although the order does not give further explanation or description as to what is "material fraud", it recognizes that only material fraud existing in the underlying transaction allows a court that is dealing with an underlying transaction dispute to determine the interests of the parties to an LC. Here, the Supreme Court reconfirms its commitment to the independence principle while carving out an exception for fraud. The order shows the Supreme Court has held a consistent attitude in this respect since the Newco case.1 In practice, it used to be easy (especially in year 1994 and 1995) to obtain an order from a PRC court to freeze payment under an LC especially when the plaintiff (usually the applicant of the LC) raises such a request pursuant to the Pre-litigation Property Preservation Procedure provided under PRC law. In order to obtain such an order, the plaintiff only needed to post a guarantee for the amount in dispute rather than provide sufficient proof of fraud. PRC courts usually do not adequately consider how to keep a proper balance between the independence principle and the fraud exception in the process of providing judicial remedies in LC fraud cases. Therefore, the Court's decision in this case is significant in that it establishes the standard of "material fraud". Whether the Court will have set the bar high enough to properly balance the independence principle and the need to protect parties in case of fraud will depend on how this standard gets interpreted in subsequent cases. The ruling of the Court is also significant in that it provides that whether fraud exists is a matter of fact to be determined by the trial court.

3. Third Party System: Another noteworthy issue in this case is how the court handled third parties in 1. Jing Zhong Zi No. 336 Judgment (1998), Issue No. 2 of the Supreme People's Court Bulletin. The English language summary of this case has been published in Shan Jianbao and Jin Saibo on Court Cases that Confirm the Judicial Acceptance of UCP in China, Summer 2000 DOCUMENTARY CREDITS INSIGHT 16. For a detailed review of this case by the author, see CHINA LAWYERS, January 1999.. 30 LC fraud cases. According to the characteristics of the independence principle and documentary transaction of LCs, courts generally should not join the issuer, negotiating bank or confirming bank (parties limited to the LC transaction) to an underlying transaction dispute proceeding. Recent judgments of the Supreme Court also express the same position that the issuer and negotiating bank should not be added to an ordinary underlying transaction dispute proceeding. Even in case of LC fraud, they should not be added before sufficient proof of fraud is provided. The fraud exception runs counter to these general principles. When material fraud is proved to exist in the underlying contract, the independence principle shall no longer prevent the court from examining the actual transaction behind the LC. Accordingly, the court has ample reason to add the parties to the LC transaction to the underlying contract dispute. When the fraud in the underlying transaction reaches the standard of material fraud, the court may grant an order to stop payment under the LC. Any such order obviously affects the interests of the parties to the LC transaction. Accordingly, the court should join the parties or allow the parties to join the suit. If the issuer and other intermediate banks participated in the LC transaction in due course are not joined, the court's judgment will determine the interests of those who are not litigating parties and bind them. Some local courts used to rashly freeze or terminate the payment under LC without joining the issuer or other intermediate banks upon the application of plaintiff who claimed fraud in the underlying transaction. To make matters worse, in such cases the banks did not even have the chance to appeal the freezing order or the final judgment of terminating payment since they are not litigating parties. In seeking to protect the interests of domestic buyers, courts in such instances sacrifice the interests and reputation of Chinese banks. Given such practices, it is important that the Supreme Court in this case confirmed the decision of the first instance court to add the issuer and the negotiating bank as third parties. Strictly speaking, although the ruling of the Supreme Court does not have precedential force, it provides a beneficial example to local courts on how to handle third parties in future LC cases.

DCW Comment: The appellate court properly recognized that the LC is independent from the underlying contract and quite properly acknowledged that in some circumstances it is necessary to examine the conduct of the parties in the underlying transaction where fraud is alleged. Neither of these principles, however, would support the suggestion that an arbitration clause in the underlying contract would require that action to stop payment on an LC be subject to arbitration because of the terms of the sales contract. In this respect, it would seem that the trial court was correct. The LC, while it may be issued because of the underlying agreement, is a separate undertaking of the issuing bank who is not a party to the underlying transaction. The appellate court quite properly recognized the significance of this point by approving the joiner of the issuer and negotiating bank. An arbitration clause in the underlying contract has no bearing on the obligation of these banks to honor a presentation. Nor is resort to judicial procedure inconsistent with the arbitration clause even between the buyer and seller. Most arbitral systems do not have the ability or inclination to grant extraordinary relief.


The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.